Question

Big Bear Hospital is a for-profit facility that pays taxes at a rate of 40%. Big Bear’s management initially estimated that their annual depreciation expense was $100,000. In a follow-up analysis, they updated this assumption only and doubled the initial estimate. Under this new assumption about the annual depreciation expense, which of the following statements is correct? [Circle your answer(s), and please show all work.]

A) Big Bear’s net income would increase by $100,000.

B) Big Bear’s net income would decrease by $40,000.

C) Big Bear’s net income would decrease by $60,000.

D) Big Bear’s approximate cash flow would increase by $100,000.

E) Big Bear’s approximate cash flow would increase by $40,000.

F) Big Bear’s approximate cash flow would decrease by $40,000.

Answer 1

Lets assume that the EBITDA = y, So we will have the calculation of Net income and cash flow from operations as follows:

Particular	Old	New	Change = New - Old
EBITDA	y	y
Depreciation	100000	200000
EBIT	y-100000	y-200000
Tax	0.4x(y-100000)	0.4x(y-200000)
NI	0.6x(y-100000)	0.6x(y-200000)	-60000
Depreciation	100000	200000
CFO	0.6x(y-100000)+100000	0.6x(y-200000)+200000	100000-60000=40000

Depreciation is added back to Net income to find the cash flow from operations as depreciation is a non cash expense

So we can see that net income decreases by 60000 and cash flow increases by exactly 40000

Therefore the correct option is C & E are correct